Government Bailout

Hey all,

This post is somewhat of a follow-through on my previous post on the financial crisis. I hope people have read my previous post as it helps you to understand the origins of the financial crisis. This post will focus more on how the US government has responded to try and stymie a complete economic collapse. I understand that most of you will be bored out of your minds if I write an in-depth post because it will be super long. Thus, I will try to focus on the important details.

So, as you guys now know, the crisis originated from the housing market and the securitization of mortgages coupled with over-leverage (excess borrowing to make investments). (Please read my other post “financial fallout” if you don’t have a clue what I’m referring to). It’s important to understand that securitization and leverage are not a bad thing per se, as they help companies to spread risk and pursue viable investments, respectively. However, as I mentioned in the other post, it is when we take these measures to the extreme is when we expose ourselves to deep problems (As you guys all know, the idea of moderation applies to almost anything in life).

As the crisis unfolded, the US government responded in its customary slow fashion. Because they did not take serious action last year when the problem signs emerged, they have been forced to take unprecedented high-profile measures since. Here’s a synopsis of the major actions taken by the government:

Fannie Mae & Freddie Mac:
What they do: These are government sponsored enterprises (“GSEs”) that help fund mortgage loans by buying them from mortgage institutions. So, essentially, they give cash to a bank and in return they hold the mortgage loans and wait for all the payments to come in. In order to fund this operation, they package (securitize) the mortgage loans into MBS (Mortgage backed securities) that they sell in the secondary market.
What happened: As the housing market got worse, and prices continued to decline, the GSEs looked in trouble; Foreclosure and delinquency rates increased (less payments to Fannie Mae & Freddie Mac) so there was uncertainty about whether the GSEs could pay off the debt they owed their private investors. Private investors who bought MBS' from these two were guaranteed fixed payments from the entities. However, since these two companies were implicitly backed by the Government, nobody really knew if the government would step in to help pay off the debt that the GSEs owed. This concern and loss of confidence in the entities made their stock price go down drastically. Eventually, they were basically bankrupt.
Government Action: In early September, the Government rescued these two by placing them into what they call “conservatorship.” Basically, this means the government takes control of the operations of the firms, and most importantly, the US Treasury backs all the debt that the firms guarantee. Therefore, it reinstates the confidence that private investors have in the firms because it becomes an explicit rather than an implicit guarantee. The government had to bailout the GSEs because a lot of banks, foreign banks and other large influential firms were dependent on the GSEs. Had they gone bankrupt, it would have caused a huge ripple effect that would have put not only firms, but also countries in trouble.

Bear Stearns & JP Morgan:
What do these entities do: Bear Stearns and JP Morgan are investment banks – firms that sell investments such as stocks and bonds in the secondary market, as well as provide financial strategic consulting advice for mergers and acquisitions. Note: Some investment banks also do commercial banking (traditional bank function: take deposits, give out loans. Citigroup is an example). Investments banks such as Bear Sterns and JP Morgan form the storied quintessential Wall Street firms where bankers adorn $5,000 Armani suits and drive around Ferraris.
What Happened: Bear Stearns had a lot of losses related to its MBS' and eventually the losses were too significant for them to bear.
Government Action: The government felt that the collapse of Bear Stearns would be too catastrophic since it was interlinked with a lot of other big name firms. Therefore, the US government facilitated a deal whereby JP Morgan purchased Bear Stearns at 7% of its market value based on its closing stock price that day. Why sell Bear Stearns so cheap to JP Morgan? Well, the US government wanted to prevent other companies from wanting to follow Bear Stearns' path. That is, if companies knew they could sell themselves for a high price, they would give up on solving their investment problems.

Lehman Brothers:
What does this entity do: Lehman Brothers was an investment bank also.
What happened: Lehman Brothers had a lot of mortgage related investments that eventually bankrupted the company.
Government Action: The government decided not to help Lehman Brothers because they felt it wouldn’t have a drastic effect on the economy. As a result, Lehman filed for Chapter 11 bankruptcy resulting in the largest bankruptcy in US history.

The collapse of Lehman affected many companies as they invested money and lent money to Lehman. Many people believe that it was a big mistake that the US government did not step in to save Lehman. We won’t know for a while whether this is true or not. Since Lehman Brothers’ collapse, the US government has been a broker in making several merger and acquisition deals such as Bank of America’s purchase of Merrill Lynch, and Wells Fargo’s purchase of Wachovia. The banks that got acquired had a lot of mortgage write-downs related to their MBS' investments so their only choice was to sell the business.

Now, the only investment banks left on Wall Street are Goldman Sachs, and Morgan Stanley. Yet, it is not sure if their business model/structure will work in the future since a lot of their profits were derived from these credit derivatives. Both firms converted to commercial banks recently as this allows them to borrow short-term funds at the cheapest rate (the federal funds rate) from the Federal Reserve (“The Fed,” or the US Central Bank). In addition, Goldman Sachs’ desperation was further reinforced when it revealed its interest in pursuing online banking to get depository funds.

AIG:
What do this entity do: AIG is insurance company that offers traditional insurance but also decided to offer insurance in the credit derivatives market.
What Happened: AIG sold a lot of Credit Default Swaps (CDS'). CDS' if you remember are basically insurance contracts. As part of these contracts, the counterparty (insurance holder) can ask for more money (collateral) from the insurance provider (AIG in this case) if the insurance provider is downgraded (resulting from financial problems). This is exactly what happened in the case of AIG as a lot of the CDS holders asked for more money from AIG and eventually the company ran out of money. An analogous situation would be if everybody suddenly crashed their car and went to the insurance company. The company would not have enough money to cover everybody.
Government Action: The government bailed out AIG because too many people had these insurance contracts. AIG has to pay back the loan within 5 years with relatively low interest rate. The company is safe for now however.

Troubled Asset Relief Program (TARP):
This is the so-called $700 billion dollar bailout bill that Henry Paulson, US treasury secretary, and Ben Bernanke, the Fed chairman, vehemently endorsed. Initially, the money was supposed to be used to purchase “toxic assets” from the banks, basically all these risky investments that nobody wanted to buy. However, with strong opposition and outrage from the people, economists, and politicians, Henry Paulson and co. decided to make capital infusions (give banks money) into the banks. The banks that the government decided to sponsor, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo, Bank of America, and JP Morgan are the biggest banks in the US. By giving them money, the government wanted to try and encourage banks to lend again - what the press has called “un-freezing the credit markets.” Economic indicators have shown that this process is occurring slowly but surely.

The government also ended up giving Citigroup, one of the investment banks, additional funds when the bank was in trouble. One week, investors suddenly lost confidence in Citigroup and there was basically a “run” on the bank as its stock price was plummeting. The government had no choice but to give Citigroup more money to stay alive.

The US treasury has spent about half of the $700 billion so far. Note: Had the government pursued the original plan, it would have been basically impossible to implement and would just be a drop in the bucket. The amount of these troubled assets are so large that $700 billion would not do much to shore up the banks’ balance sheets. The banks are hoping that these assets will be worth more when the housing market recovers.

Why bailout banks: Although the government would prefer not to interfere with what is happening in the markets, banks are so intertwined with the rest of the economy that they were left with no choice. Not only do they have countless investors that they owe money to, but they also are responsible for providing companies with short-term loans to cover costs. The majority of firms in the US are small firms that borrow money from banks to pay wages and operating costs to keep their businesses open. As the banks run into trouble and have less money, they refuse to lend money out to these small businesses because they need it for themselves. This causes a huge problem where businesses across the US have to go bankrupt as a result. Therefore, the US government has been trying to encourage the banks to lend out money to help business to continue.

Is their approach the best or correct way: Honestly, we do not know. What the government is doing now is not in any economics textbook. They’re basically doing everything on the fly so that’s not very reassuring. A prime example of the government’s uncertainty is the TARP and how its purpose changed. Originally, Henry Paulson and Ben Bernanke (Fed chief) said that buying the toxic assets is our only and best option. Yet, a couple weeks later they used the money not to buy the toxic assets but to give the banks capital. The truth is, Ben Bernanke and Henry Paulson do not fully grasp these mortgage securities (MBS', CDOs). The people who really understand how they work and the best way to deal with them are not the CEOs, or the people high in government, it’s the statisticians, geeks and mathematicians that are buried within the corporate firms.

It’s true that ex-ante, choosing Ben Bernanke and Henry Paulson to deal with this crisis would probably be our best option. However, in reality, things do not play out as we expect. Ben Bernanke is an expert on the Great Depression and he’s written many papers on how government could have prevented that crisis. Yet, he’s implemented all his solutions and the results are not what he expected. Henry Paulson used to be the CEO of Goldman Sachs, he understands the investment banks inside out. He should know how to get banks to lend and help the economy. Yet, despite all these problems, the economy is not as bad as everybody’s making it out to be. The Great Depression was MUCH MUCH worse.


The Big 3 Auto Companies (Ford, GM, Crystler):
I’m sure you guys have all heard about how the Big 3 have gone to Congress trying ask for money. What should Congress do? Well, in my opinion, the best option would be to let GM and Chrysler file for Chapter 11 Bankruptcy protection. However, I feel it is inevitable that the government will give them money sooner or later. If they do not grant it now, Obama will make sure they do. There’s a lot of politics at play here.

Fundamentally, the Big 3 are structurally unsound and they have a business model that does not work - too many brands, and too many SUVs and gas-guzzlers. They have a competitive disadvantage in that they are binded by the United Auto Workers (UAW) union in terms of pay scale, pension, and health costs. I feel that giving them money will only prolong the inevitable. In their plan to Congress they proposed certain measures to help cut costs by $4 billion a quarter, yet their costs are still in excess of $14 billion a quarter. You don’t need a PhD to figure out that the math does not work out. They have to file for bankruptcy so they can change those contracts and figure out a better business model. Also, the jobs that would be lost from their bankruptcy would be partially offset by the other carmakers in the industry.

What has happened globally?

Europe:
In Europe, there’s been a similar response to the US whereby a lot of banks, especially in the UK, have been given capital infusions. There has also been a fair number of bankruptcies. The European and US economy continue to be closely intertwined.

Asia:
Asia also has been greatly affected by what has been happening in the US. China’s growth rate has slowed considerably. They have mandated two economic stimulus packages to try and sustain an 8-9% growth rate.

What’s in store for the future?
Obama has done all the right things so far. He’s assembled an extremely skilled economic team comprised of both experienced economists and knowledgeable academics. (The team understands both bureaucracy and economics, because you need both to get things done in Washington). Yet, they have a tough task ahead of them and choosing the right team ex-ante does not guarantee results. Obama is planning a large stimulus plan coupled with several projects to increase jobs (he promised 2.5 million new jobs by 2011?): Obama's stimulus package



The government has also started to try and address the housing issues: US Eyes Plan To Life Home Sales. They’re lowering mortgage rates in an attempt to increase demand for houses and in turn, increasing house prices. There are still a lot of proposals floating around with respect to addressing the housing market. As we now know, stabilizing the housing market is a key to stabilizing the economy.

In the past, consumer spending was the driver of 60-70% of GDP. Now that consumer confidence is at an all-time low, consumer spending has been cut back drastically. Somehow Obama has to figure out how to get Americans to start spending their money again.

Also, exports are going to decrease substantially now because the dollar is strong (foreign investors are buying a lot of US treasuries, sold in US dollars and the closest thing to a risk-free asset, so there’s a high demand for US dollars => appreciating/strong dollar). But a shortcoming of this is that US goods are more expensive since a unit of foreign currency has less purchasing power now. This will hurt the US as well.

Well, that was a longer than expected post. I’m sorry for the lengthiness and don’t know if anybody’s going to read all of this. Haha.

- Sean

Sources:
http://knowledge.emory.edu/article.cfm?articleid=1178
http://en.wikipedia.org/wiki/Economic_crisis_of_2008
http://en.wikipedia.org/wiki/Global_financial_crisis_of_2008
http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2008
http://www.nytimes.com/2008/03/16/business/16cnd-bear.html
http://online.wsj.com/article/SB122833771718976731.html?mod=article-outset-box

Good article if you want more technical in-depth reading on securitization:
http://economistsview.typepad.com/economistsview/2007/10/the-role-of-sec.html